Repo Rates

The Repo rate is the interest rate at which the Reserve Bank of India lends to commercial banks.

A cursory glance at the business section of newspapers shows us the concern or elation every time the Reserve Bank of India (RBI) hikes or reduces the Repo rate. Commonly called policy rates outside of India, a change in the repo rate can result in an upswing or downswing of markets. The obvious questions in the minds of most readers are how does this impact our daily lives and is this the same interest rate that commercial banks levy on us? This article attempts to answer these questions and will hopefully leave the reader with a basic understanding of the significance of repo rates.

The Repo Rate:

The Repo rate (Repo is an acronym for repurchase) is the interest rate at which the RBI (Reserve Bank of India) lends to commercial banks.

The central bank of a country is usually an independent institution that is set up with the specific intention of maintaining the stability of price and total outputin the economy ( this article will focus on the former). Price stability would result in consistent, and hopefully low, levels of inflation in an economy. Inflation, as Ludvig Von Mises describes it, is an increase in the quantity of money without a corresponding increase in the demand for cash holdings. High inflation leads to people having to spend more money to obtain the same amount of goods and services. The point to note here is that money, like all other commodities, is governed by the principles of demand and supply.

The RBI utilises several mechanisms to maintain price stability but its primary tool is the repo rate. This rate, which is charged by the RBI, is different from the interest rates charged by commercial banks. In a commercial bank, if the interest levied is 8%, a loan of Rs. 50,000 would result in an interest sum of Rs. 4,000 after one year. So, the loaner, usually an individual or business, has to pay back Rs. 54,000 to the bank at the end of the year. The RBI however, does not lend to individuals or businesses, it instead lends to commercial banks in certain circumstances; central banks are usually referred to as the lenders of the last resort. The repo rate is the interest at which the RBI grants short term loans (15 days) to commercial banks facing shortage of funds.

Commercial banks borrow from the RBI on a regular (daily) basis, which explains the high influence of the repo rate. In the week of Mar 15 – Mar 20, 2015, commercial banks in India borrowed Rs.72,672 crores from the RBI at 7.75% rate of interest.

Fig: Repo rates from March 2004

Transmission Mechanism:

Hypothetically, if the RBI lowers the repo rate from 8.0% to 7.5%, commercial banks can borrow from the RBI at a cheaper rate. As the RBI has decreased the cost of borrowing for commercial banks, the demand for money will increase; as commercial banks can now borrow more money they can use these funds to lend more money to its customers. In essence, by cutting the repo rate the RBI increases the supply of money (the liquidity) in the market. Commercial banks will now have the maneuvering capability to decrease the lending and deposit rates charged to customers. A cut in the lending rate will induce more people to borrow while a cut in the deposit rate will induce people to save less and spend more. Both these mechanisms result in an increase of the disposable incomes of individuals, which further leads to increased consumer spending. This sequence of events may not necessarily happen all the time, but a change in the repo rate generally gives the banks an impetus to act in the direction of the rates.

However, it must be kept in mind that a change in the repo rate by the RBI can also impact the exchange rate of the rupee. With all other factors remaining the same, a cut in the repo rate can lead to the depreciation of the rupee and vice versa. A fall in the repo rate can make most rupee denominated financial assets less attractive to investors than foreign currency denominated assets. The rate of return on most financial assets in a country will be tied to the interest rates (government bonds, equity, etc). Thus, when the repo rate decreases, the rate of return to the foreign investors also decline. This will precipitate a decrease in inflow of foreign currency into the economy, thereby reducing the demand for rupees which will cause the rupee to depreciate. The fallout of this is that imports become more expensive and the prices of exports go down.

A change in the repo rate can cause an increase or decrease in the supply of money in the markets, which has profound implications on the lives of people as this directly impacts the price of goods and services that we consume on a daily basis.

Anupam Manur is a Research Associate at Takshashila Institution and can be found on twitter @anupammanur

Varun Ramachandra is a Policy Analyst at Takshashila Institution and can be found on twitter @_quale

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